Money Illusion and Housing Frenzies Markus K. Brunnermeier and Christian Julliard NBER WorkingPaper No. 12810 December 2006 JEL No. G12,R2 ABSTRACT A reduction in inflation can fuel run-ups in housing prices if people suffer from money illusion. For example, investors who decide whether to rent or buy a house by simply comparing monthly rent and mortgage payments do not take into account that inflation lowers future real mortgage costs. We decompose the price-rent ratio in a rationalcomponent -- meant to capture the proxy effect and risk premia -- and an implied mispricing. We find that inflation and nominal interest rates explain a large share of the time-series variation of the mispricing, and that the tilt effect is unlikely to rationalize this finding. Markus K. Brunnermeier Princeton University Department of Economics Bendheim Center for Finance Princeton, NJ 08540 and NBERmarkus@princeton.edu Christian Julliard Department of Economics London School of Economics Houghton Street London, WC2A 2AE United Kingdom C.Julliard@lse.ac.uk

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Introduction

Housing prices have reached unprecedented heights in recent years. Sharp run-ups followed by busts are a common feature of the time-series of housing prices. Figure 1 illustrates diﬀerent real housing price indicesand shows that this phenomenon has been observed in several OECD countries.
Panel A
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275 250 225 200 175 150 125

P anel B

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Figure 1: Residential property (real) price indices for agroup of Anglo-Saxon countries
(Panel A) and for Scandinavian countries and other European countries (Panel B). Base period is 1976:Q1.

Shiller (2005) documents similar patterns for other countries and cities over shorter samples. Moreover, Case and Shiller (1989, 1990) document that housing price changes are predictable and suggest that this might be due to ineﬃciency in the housing market....